When prices rise in different sectors of the economy, you hear analysts talking about inflation. Inflation is the devaluation of currency over timemeaning that as goods and services become more expensive, the purchasing power of your money decreases.
People often first notice inflation by realizing that something they buy on a regular basis is more expensive than usual – perhaps your receipt from your grocery store or gas pump is higher than expected. But not all prices are rising at the same rate some consumers can find they don’t spend more than they did a year ago.
This begs the question: how is inflation measured? Although it seems like a simple question, calculating inflation is complicated. The economy is huge and complex; not everyone is interested in the same goods and services.
To understand how inflation is measured, we need to understand the consumer price index.
Key learning points
- Inflation refers to an overall increase in the price of goods and services within the economy.
- Changes in a price index, such as the CPI, measure inflation.
- Other price indices, such as the PCE and core inflation, help overcome some of the shortcomings of relying solely on CPI.
What is Inflation?
Inflation is a reflection of the overall price change throughout the economy. Inflation refers to a general price increasewhile deflation is a general fall in prices.
Do not confuse these terms with stagflation, which refers to a specific scenario where both inflation and unemployment are high. Stagflation is tricky for the Fed, as raising interest rates to fight inflation could lead to further unemployment.
Analysts calculate inflation by observing the price changes in a basket of goods and services. This basket usually contains a large number of items that most Americans purchase in their day-to-day lives, such as gas, groceries, and medical supplies. Data collectors record the prices of these items each month to determine whether they have generally gone up or down.
Inflation reports are usually released every month. Inflation rates can be volatile from one month to the next, especially if you focus on an individual good or service. So these reports also show changes over 12 months to provide a more complete picture of overall price trends.
Measures of inflation
While the US consumer price index (CPI) is the most well-known measure inflationtry various other measures to absorb price changes. Each of these measures can be useful to different consumers and businesses.
Consumer Price Index
The Bureau of Labor Statistics (BLS) is responsible for the CPI. The CPI represents the change in price that consumers pay for goods and services over time.
The CPI figure that most consumers hear in the news reflects the entire package of goods and services. However, indices are also available by geographical area and for specific industries of goods and services.
The CPI weighs each item in its basket based on how much the average American spends on that item. In other words, goods and services that make up a lower percentage of US spending have a more negligible effect on CPI. The BLS uses the Consumer Expenditure Surveys (CE) program to review the importance of each item within the basket of goods and services.
Articles enter the CPI sample through a process called initiation. A CPI data collector goes to a store and selects an item from a pre-selected category. For example, they can opt for a cereal box that comes in two sizes. Data should be collected on how many people purchase each size to determine their likelihood of purchase. Then the data collector randomly chooses one of the sizes and tracks the price every month.
Items naturally rotate out of the CPI basket every four years. The BLS records the prices of approximately 80,000 items per month, divided into eight groups, including:
- Food and drink
- Housing
- Clothing
- Transport
- Medical care
- Recreation
- Education and communication
- Other goods and services
Personal consumption Expenditure Price index
Another popular measure of inflation is the Personal Consumption Expenditures (PCE) price index. While not as widely known as the CPI, the core PCE (meaning it excludes food and energy) price index is important because the Federal Reserve uses it in setting monetary policy. The Bureau of Economic Analysis is developing this measure.
Like the CPI, the PCE price index includes a basket of goods and services, but the relative weights of different categories are in some cases very different. Here are some of the critical differences.
2022 CPI reports gave shelter a “relative importance” (the percentage of money spent by consumers on this category) of about 34%. In comparison, the PCE weighed shelter around 16% during the same period. Similarly, in 2015, the BEA reported that it weighted the importance of medical expenses at 22%, while the CPI gave it a relative importance of 8.4%.
According to the Brookings Institute, one reason for the weight difference for medical expenses is that the PCE price index includes all consumer items. For health care, the PCE captures costs, such as premiums and deductibles, in addition to those covered by employer-sponsored health insurance plans and Medicare. The CPI, on the other hand, only reflects the direct costs for the consumer.
The result of these different weights is that they affect their indices differently. For example, changes in healthcare costs will have a major impact on PCE, while changes in house prices will have a greater impact on CPI.
Numerous articles argue whether CPI or PCE is the better index. The PCE has a reputation for being less volatile than the CPI. But others prefer the CPI because they think it better reflects the impact of inflation on consumer spending.
Core inflation
Core inflation can use any number of indices, such as the CPI or PCE, as a base. Then each month it omits certain items, such as gasoline and food prices; these items can be volatile and are only sometimes representative of general price developments.
As expected, removing the most volatile items from the inflation measure provides a more consistent picture of inflation. In some cases, however, core inflation may still be biased.
To help understand why, we can compare core CPI to the Cleveland Fed’s trimmed average CPI. While the core CPI excludes the same items each time it is measured, the trimmed average CPI removes the goods and services that are most volatile in a given month.
One can imagine why the trimmed average CPI approach would lead to more predictable results. For example, one-off events such as natural disasters can cause a sudden and unexpected increase in the price of usually stable items. Adjusting each month for those events means that the trimmed average CPI will more closely represent overall price trends.
Why are there so many ways to measure inflation?
When we hear news reports about inflation numbers, we usually hear CPI data from the BLS. But as you must be clear by now, the CPI is not perfect. In reality, no measure of inflation is completely accurate, and just focusing on the CPI doesn’t give us the whole story.
At the same time, different people will care more about price changes in different parts of the economy. Railway companies, for example, will worry less about the price of a liter of milk and more about the cost of diesel fuel.
Similarly, consumers living in Chicago will be more concerned about inflation rates for their city than they are about inflation in Los Angeles. These nuances mean that multiple indices are needed to paint a complete picture of inflation.
Limitations of the CPI
The consumer price index is limited in what it can tell us and in its accuracy. When looking at the CPI, keep in mind that it doesn’t tell you the actual prices of items across the country. You can’t look at the report and determine whether eggs are cheaper in Montana or Oklahoma, only where the price of eggs rose faster.
The CPI also does not apply to all population groups. For example, the CPI-U records prices for items sold in urban populations. The older people buy different things than teenagersso rising overall inflation may not reflect an increase in the price of items you buy.
The CPI should not be used to determine the cost of living across the country. The BLS calls the CPI a “conditional measure of the cost of living” because it does not take into account the costs incurred by various social and environmental factors (including taxes).
There will always be sampling errors and non-sampling errors regarding data collection. Consider browsing more than one index to understand general price trends in the US
last words
Inflation represents a general rise in prices for goods and services in an economy. Analysts measure inflation by looking at price movements within an index. The most well-known price index is the CPI, which the BLS publishes monthly. There are other measures of inflation, such as the PCE price index and core inflation. These measures help address CPI issues. For example, they sometimes remove highly volatile items or weigh swing-sensitive items differently.
Measuring inflation is a complicated task, which means a single measure of inflation may be skewed or not represent certain regions or industries. Having multiple measures of inflation helps paint a complete picture and addresses the nuances of a complex national economy.
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